Home > Macro/Monetary Theory > A Modified Gold Standard

A Modified Gold Standard

David Gordon has a piece on Mises.org critiquing Steve Forbes’ book Money. The piece is rife with confusion but I don’t want to do my usual Mises.org routine and go line by line pointing out how each point is mistaken. (They never seem to respond when I do that, which is odd because I know they notice, I can see the hits…) For what it’s worth, I haven’t read the book but from what I can gather from the quotes in Gordon’s post, it is also somewhat confused.  This quote, however, got me thinking.

“[Forbes’] gold standard allows the money supply to expand naturally in a vibrant economy. Remember that gold, a measuring rod, is stable in value. It does not restrict the supply of dollars any more than a foot with twelve inches restricts the number of rulers being used in the economy.”

This got me thinking about how gold could be used as a “measuring rod” for money without being “convertible” in the traditional sense of the word and I think that thinking about it this way may help to explain the relationship between money and debt.

Imagine that you have an economy where physical gold is commonly used as money. A bank enters this economy and offers the following deal: You can borrow X “dollars” (a unit which the bank makes up out of thin air).  At some point in the future you must repay the same number of dollars or a given quantity of gold. Let’s say that the exchange rate is one oz. of gold per dollar so if you borrow 100 dollars, you can repay either with 100 dollars or with 100 oz. of gold or any linear combination of the two. The bank has only 1 oz. of gold which it keeps in the vault to act as the “standard gold oz.” like the official meter (or was it the foot?) that the French (or was it the English?) have in a vault somewhere. If you come in to pay off a debt using gold, it is compared to the standard oz. for weight and purity. Otherwise, the bank has no gold, nobody “deposits” gold and the bank does not stand ready to sell gold for dollars or dollars for gold in the traditional sense of “convertibility.”

Furthermore, assume that the contract specifies that, if the borrower does not pay the appointed quantity of dollars and/or gold by the specified date, that the bank (by way of the courts and police) will seize real goods from the borrower which can be traded for the requisite quantity of gold. And assume that only people who can post sufficient collateral are allowed to borrow so that nobody can default.

Now, first question: How much “money” (dollars) can the bank create?

Answer: As much as people are willing to borrow.

Of course, people will only be willing to borrow these dollars if other people are willing to take them in exchange for goods. So does it make sense for people to take these dollars even though they are not “convertible” in the traditional sense into any “real” good?

Yes.

Why?

Because the dollars are convertible. The person who borrows them and spends them today will need to get them back, or else get gold back, or else forfeit some quantity of real goods at some point in the future. They are contractually obligated to do this. So if somebody comes to you and wants to buy seed corn with these dollars and you understand the contract that they signed with the bank and you believe that this contract will be enforced, you can accept the dollars and hold them until the loan comes due and be assured that the borrower will be willing to trade you some portion of his crop (or other goods) to get those dollars back.

Next question: How is the price of a dollar in terms of gold determined?

First of all, let me say that what Forbes seems to mean by the “value” of money is the price of gold and this is what Gordon is erroneously interpreting as the subjective value of money and that is a source of much of the confusion in his criticism. But putting that aside, what forces are acting on the exchange rate between money and gold and how, if at all, is this rate “fixed?”

First of all, it should be fairly obvious that the price of a dollar cannot rise much above 1 oz. of gold. This is because only the borrower has an ultimate use for these dollars (paying off the loan) and he will not be willing to trade more than 1 oz./dollar to get them. If he had to pay 2 oz. (or other goods which he could trade for 2 oz. of gold) he would instead just use the gold to repay the loan.

On the other hand, the borrower will always be willing to pay up to 1 oz./dollar because if he can get dollars cheaper than that, then the difference represents a surplus to the borrower. (If you are imagining a kind of hold-up problem, just imagine that there are a hundred borrowers bidding for the dollars.)

So this type of “convertibility” should fix the exchange rate between gold and dollars right around the rate specified in the debt contract. This does not depend on the quantity of dollars that are created this way, the quantity of gold in bank vaults or the quantity of gold relative to other goods.

Now if there is some liquidity preference for gold or dollars relative to the other, the exchange rate might deviate slightly in one direction or the other (and likewise for risk preference). The magnitude of the liquidity preference will likely depend on the quantity of dollars and gold in circulation so these things may have a marginal effect on the exchange rate between dollars and gold and this will factor into the interest rate charged by the bank and how prices change over time in a more complicated model but just ignore all that for now. And obviously, the quantity of gold and other goods affects the price of gold (and therefore dollars) relative to other goods.

The important point is that liquidity preference is not the sole (or even the main) explanation for the value of a dollar. It explains a small deviation from a certain value relative to other less liquid assets but it does not explain the existence of any value in the first place. That depends on the real assets which someone is contractually allowed/obligated (depending on how you look at it) to exchange them for. This means that it is the quantity of money relative to the quantity of debt which is the main anchor holding the “value” of a dollar in place.

“Well that’s all well and good Mike but there are no gold clauses in debt contracts so this isn’t how the real world actually works” I can hear the skeptics reply. But the skeptics are wrong. We no longer have a fixed gold “measuring rod.” But we still have fixed convertibility between dollars and real goods built into the debt contracts that create money. It’s just that the goods and the rate are not the same for everyone.

If you want to borrow money to buy a house, you put the house up as collateral. The contract specifies that if you do not repay a specified number of dollars by a specified date, the bank (via the courts and police) will seize your house (a real good). It’s the same thing.

We all (Keynesians, Austrians, monetarists, whatever) act like when they suspended convertibility of dollars into gold at a fixed rate for everyone, they severed all concrete (read: “contractual”) ties between money and real goods and money just sort of magically behaves as though it were still backed by something even though it isn’t.  That is not what happened.  They only severed one particular kind of convertibility into real goods.  But this does not require everybody to be able to exchange dollars for real assets at a given rate, it just requires somebody to be able to.  And the ability of debtors to “convert” dollars into real assets at a contractually fixed rate remains.

Of course, since this rate (and the particular goods) can vary from one contract to another, it is possible for the price of a dollar, measured in any (and for that matter all) particular real good(s), to drift over time and modelling that is a complicated matter which I have been attempting. But any attempt to model it which ignores debt entirely and assumes either that liquidity preference is all that matters or that there is no reason for money to be valuable at all except for some form of mass delusion is like trying to model the position of a sailboat based on the direction of the wind without realizing that the anchor is down.  The wind matters.  The length of rope and the depth of the water matter. But you can’t really make sense of how or why they matter if you don’t notice that there is an anchor involved.

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  1. October 20, 2014 at 10:22 pm

    “the dollars are convertible. The person who borrows them and spends them today will need to get them back, or else get gold back, or else forfeit some quantity of real goods at some point in the future.”

    That’s an excellent way of putting it. I’ll file it away to use in my next argument with a quantity theorist.

    Just wondering: I remember some time back you were worrying about how repaying loans with interest means that the bank must always increase the money supply. Is that still your view? Because the answer I always give to my students when they ask about that is that the interest can be paid in commodities or something, and no additional money is needed.

    • Free Radical
      October 20, 2014 at 11:03 pm

      Thanks Mike. That is sort of my view but it’s a bit complicated. To stick with the model in this post, it is possible that, for example, the interest could be paid in gold and the principle paid in dollars. The interest would then simply represent the fee paid to the bank for the use of the extra liquidity. The bank could then spend the gold on whatever and there would be no problem.

      When all interest and principle must be paid in dollars and the nominal interest rate is positive, it must be the case that either the money supply is increasing or some people are defaulting. This is where the way in which the money supply expand becomes important. My point is that if it only expands through borrowing, you will eventually run into a problem where further borrowing is not sufficient to support continued growth of the money supply and everything falls apart. But if money leaks into circulation somehow, then this is not so obvious. One way this might happen is by ever-expanding government deficits financed by “new” money. Another way is if interest payments go onto bank balance sheets as profits and they spend them back into the economy. I think I can show that the latter will not be enough on its own, given the prevailing inflation expectations, but at this point I haven’t done that.

  1. November 24, 2014 at 1:47 am

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